Money-Furnace VXX Is Unseated by Flamethrowing XIV

By Brendan Conway

Something unusual just happened in the alphabet soup of volatility: The complex exchange-traded note built for short, quick bets on market gyrations is, for the first time, smaller than an equally complex note used for the opposite purpose.

The news is at first blush of limited interest. Barclays iPath S&P 500 VIX Short-Term Futures ETN (VXX) has fallen behind VelocityShares Daily Inverse VIX Short Term ETN (XIV) in assets under management, a spokesperson for the makers of the latter ETN tell Barrons.com. The pair entered Friday’s trading session neck-and-neck in terms of assets under management.

EPA

Playing with fire

Here’s why it is interesting: This was bound to happen sooner or later due to the way the first of these ETNs burns through money and the second tends to accumulate it. This week, part of what we’re seeing is simply traders resetting their hedges by buying the thing that has lost — the bull ETN — and taking profits in the recent gainer.

But the question now is whether too many investors catch on to what XIV can do, and make it too big for its britches. (In case it’s not clear from the names, both are hugely risky trading instruments. They’re not for buy-and-hold investors — but they’re useful gauges of what the hot money is up to.)

Here’s the background. The VXX has been a money furnace for five years. Launched shortly after the financial crisis as a means of owning volatility futures in an exchange-traded package, it has fallen an annualized 62% over five years. That’s annualized, as in, falling an average of 62% a year.

Knowing a deal when they see one, investors have shoveled more than $6 billion into this exchange-traded note over the period, according to XTF.com. Back-of-the-envelope math tells you VXX has burnt up more than $5 billion, since it manages about $745 million as of this week.

In fairness, the ETN does exactly what its index instructs it to do, and its users at this point have no excuse for not knowing. It churns through a portfolio of futures contracts in exactly the opposite manner an intelligent investor would, buying whats are usually expensive futures and selling them after they’ve cheapened. Think of it like a very expensive options contract.

The new asset leader, VelocityShares Daily Inverse VIX Short Term ETN (XIV), is a very different beast. This one delivers the opposite of VXX’s index. So if the one seemingly falls and falls, shouldn’t the other rise and rise? Most of the time, yes, it does. But matters are more complicated than that.

The VelocityShares ETN is sort of like a high-octane bet on market confidence. As long as investors aren’t paying up for stock-market insurance, this one is likely to keep rising. As it has as it posted a three-year annualized return of 24%, well ahead of the S&P 500′s 13%.

But its turnaround can be sharp, as it was in January. In a month when the S&P 500 fell about 3.5%, the ETN dropped nearly 18% thanks to changes in the “term structure” of the volatility futures curve. Essentially, the normally expensive futures contracts it sells got cheaper, and the normally cheap ones it buys got pricey.

The volatility fund has been acting as if it has more leverage to the S&P 500 than the ETFs whose names tell investors they’re getting 100% or 200% leverage versus the index, like ProShares Ultra S&P 500 (SSO), or Direxion Daily Financial Bull 3X Shares (FAS).

Over the last two years, investors got about 250% leverage on each day’s moves in the SPDR S&P 500 ETF (SPY), NDR finds. As the attached chart shows, that’s more than the leveraged ProShares Ultra S&P 500. It’s also more than the double-leveraged ProShares UltraPro S&P 500 (UPRO). For every 0.7% move in the S&P 500, the ETF jumped or slumped 2.4%-2.5%.

“On an absolute basis, it is obvious that the VIX fund is a better alternative to trading the markets,” the NDR duo write.

So could the volatility ETN get too big for its britches? It’s happened before. Moreover, there’s really no way of knowing ahead of time.

Two years back, VelocityShares Daily 2x VIX Short-Term ETN (TVIX) came unhinged from its index after the creation of new shares was cut off for several weeks. Its trading was unpredictable over the period in question.

It’s just a healthy reminder to be wary of bulls stampeding in unison. Or, for that matter, bears.

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.

Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.